Origins and Tragic End of Sub-Mortgages: It’s the Government, Stupid!

What happens when government intervenes in order to create an “ownership society?” and curb “predatory lending?” The target of libertarians, a free market, recedes farther into the future.

“ Shelter from the FHA

“As part of a continuing legislative reaction to the slide in the housing market and the sub prime mortgage problem, a bill to modernize the Federal Housing Administration has recently passed the House of Representatives.

“Similar legislation passed out of committee in the Senate, but the full Senate has not yet acted. Although the "Expanding American Home Ownership Act of 2007" promises to make it easier to own a home, some troubling factors may leave taxpayers on the hook for loans that cannot be paid back. Like many of Washington 's policy initiatives, this is another bad public policy wrapped in the language of love.”

What exactly is Congress now preparing to fix?

It is hard to tell what bailouts and new regulations are coming. Obviously members of Congress include people who are commiserating with the people who lose their homes in foreclosures and/or angry with the lenders. Borrowers may not be smart enough to avoid bad loans, and lenders are, after all, dirty rotten scoundrels.

Something will be done; there are just too many foreclosures, too many crashing shares in the stock market, as well as "junkier" bonds.

Will the cure include un-doing what caused this all? Were interest rates lowered too far in trying to recover from the Dot Com Bubble bursting? Were other government actions also responsible for setting up this mortgage market crisis? Forcing lending to “communities of color” and other neighborhoods against which banks had allegedly been discriminating.

Remember the CRA?

The Community Reinvestment Act (CRA), enacted by Congress in 1977 (12 U.S.C. 2901) and implemented by Regulations 12 CFR parts 25, 228, 345, and 563e, is intended to encourage depository institutions [national banks] to help meet the credit needs of the communities in which they operate.

The CRA requires that each insured depository institution's record in helping meet the credit needs of its entire community be evaluated periodically. That record is taken into account in considering an institution's application for deposit facilities, including mergers and acquisitions. ( See CRA Ratings ) CRA examinations (see Exam Schedules) are conducted by the federal agencies that are responsible for supervising depository institutions: the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency (OCC), and the Office of Thrift Supervision (OTS).

Under these regulations, when the OTS rating of a lending/investing institution falls too low, the sanctions the OTS:

(1) May order that a bank's covered interstate branch or branches be closed unless the bank provides reasonable assurances to the satisfaction of the OCC, after an opportunity for public comment, that the bank has an acceptable plan under which the bank will reasonably help to meet the credit needs of the communities served by the bank in the host state; and

(2) Will not permit the bank to open a new branch in the host state that would be considered to be a covered interstate branch unless the bank provides reasonable assurances to the satisfaction of the OCC, after an opportunity for public comment, that the bank will reasonably help to meet the credit needs of the community that the new branch will serve.

(3) Penalties ranging from $5,000 to $1,000,000 per day.

What Did the Banks Do?

The CRA forced banks to lend to otherwise uncreditworthy consumers (read the article by Thomas J. DiLorenzo from 2007, who inspired me to research this topic).

In making loans of the types covered, including mortgages, the banks became creative and more liberal. The demand for mortgages was also causing an interest in making more profits in mortgages, due to the housing bubble.

There have been long periods in banking history during which the mortgages they let were kept on the books, rather than being sold. Borrowers with high qualifications could always be found by being selective. Further income after the closing on a mortgage could also be earned by owning the mortgage and processing it for its life, the greatest benefit would be the interest earned and the restoring of the cash capital.

Higher Rates for the Lower Grades. When faced with the “liberalizing” rules of CRA, other, less qualified borrowers had to be included. These mortgages were riskier. At first, the normal qualification process based on credit rating and ability to repay resulted simply in higher interest rates, to make up for the higher risk. Not enough loans resulted from this, as the clients in question often faced higher monthly payments than they could afford.

Further changes were required to meet CRA rules. Several other forms of lending resulted:

Adjustable Rate Mortgages (ARMs), whose initial interest rate was 1 or more points below the current standard rate. The “adjustable” feature kicked in after 2 or 3 years, with the interest rate then being “reset” to a certain number of basis points above one of the leading index rates such as the 1-year constant-maturity Treasury (CMT) securities, the Cost of Funds Index (COFI), and the London Interbank Offered Rate (LIBOR). The rate could then periodically move up (by set increments, up to a contractual maximum) or down in step with that standard rate. The hope of the client obtaining an ARM would be that his or her income would rise enough to cover the payments.

Options ARMs , on which the interest rate adjusts monthly and the payment adjusts annually (up to a contractual maximum), with borrowers offered options on how large a payment they will make. The options include interest-only, and a "minimum" payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed "negative amortization". Again, the hope is that income increases to meet the growing obligation.

Further Variations, including low or no down payment, “low-doc” or “no-doc” loans (where formal proof of ability to repay is lightened or omitted). Couple this with the borrower having pay cut or losing a job or the negative equity due to a falling real-estate market, and you have a house of cards (pun intended). A house with a falling value is sometimes abandoned, since even if the payments remain affordable, the financial incentive to make them is substantially weakened. The borrower walks away and defaults on the mortgage.

What Else Did the Banks Do?

The CRA changed the behavior of all of these national banks. What did they face? Keep doing sound banking, face unconscionable fines and closures, or accept losses due to defaults. I do not feel sorry for banks. I just demand justice. The government-banking complex bothers me. However, this was an anti-bank squeeze play; an injustice.

Mortgage defaults were bound to increase. Defaults would come in greater numbers than with the previous generations of loans. What did they decide to do? Just as in previous times, occasionally, to obtain cash for new lending, mortgages were sold to investors, now this made it convenient to avoid bearing the full burden of these defaults. The commissions and closing fees were kept by the originator, but a small amount given up in discounts on the mortgages sold.

Mortgage defaults results in not only the ending of the income stream of the monthly payments, but also taking a loss on repossessed homes. The market is not kind and considerate when you are in a hurry to sell unoccupied, possibly damaged property. The risk of carrying these riskier loans had to be mitigated. The legal way out, after having been forced to grant the loans, was to turn around and sell them. They might continue to service them, but they had to dump them.

The investment community probably bought these mortgages at a discount based on the grade of the loan. Now, not wishing to bear the full burden of this risky bundles of mortgages, these investors sliced and diced them and sold these in turn to large institutions, some of them foreign banks.

The banking system created mortgage-backed securities (MBS), collateralized debt obligations (CDO) and structured investment vehicles (SIV).

Then the Chickens Come Home to Roost

However, as the defaults on the underlying mortgages increases, many more people and institutions are hurt. They can no longer carry these investments on the books at cost. The derivatives values fall. MBSs are forced to be sold at fire sales. They must take write-downs.

32 sub-prime lenders that had become "defunct" since early 2006

Guess what happens to their stock values? Guess what happens to the CRA-controlled banks that started this? What happens to their ability to lend and what happens to their share prices?

Bust.

What Should be Done?

Repeal the laws that caused this all.

When the housing bubble bust ends, having a flexible lending industry will not do any harm. The public must be warned, however, should the same cycle begin again. But no bailouts should be made, no adding of “predatory lending” laws and regulations.

The investors of the nation deserve to be left alone. Their capital should be allowed to flow to where it will grow and work the most effectively. After all, in every legal free market exchange (including loans) both parties benefit, otherwise the motivation to make the exchange would be absent. Moreover, we know that government is the absence of that, absence of free market.

The whole CRA scheme should be abandoned. The taxpayers should not be on the hook for bailouts or regulations that are more burdensome. However, that is precisely what Congress will do to us, keep CRA, add more regulations, and take our money to bail out the losers. And cause more inflation by increasing the money supply (have you been paying attention to the credit market help coming from the Fed?).

Ben Bernanke is caught between the rock and the hard place, lowering rates to fight inflation versus a “stimulus package” to prevent a recession. But I do not feel the least bit sorry for him, for he (in his “private” central bank) and his cohorts in the government sector have caused this stagflation, credit crunch and recession.

It's the government, stupid!